The Danish Dilemma: What the Euro Crisis has Wrought

Denmark, like Switzerland, offers negative interest rates. This is not just bills either, but in Denmark's case, rates are negative through the 2-year tenor. Swiss rates are negative through the 4-5 year sector. The Danish situation is similar to Switzerland's. As money seeks refuge from the uncertainty in the euro zone, especially with the newly discovered redenomination risk, Denmark has experienced a surge of capital inflows. The central bank says offshore holdings of Danish bonds has risen 2.6% in the past month to DKK242 bln (~$41 bln), which is about a third of Denmark's debt. Denmark opted not to participate in monetary union, but it does participate in ERMII and keeps in currency in exceptionally narrow range against the euro. The range that it is kept in is tighter than the 1% regarded as fixed under Bretton Woods. Its central rate has not changed since 1987 (just shifted to the euro from the deutschemark). The central bank has a single mandate: maintain the peg. It has two tools to do so, interest rates and intervention. Both are being deployed currently. As the krone rises against the euro, the central bank has cut interest rates both last week and this week. It has also intervened. The central bank argues that there is no limit to its reserve accumulation. After all there is no limit to the amount of krone it can print in order to sell during intervention. In reality there probably is a limit though it might not be known a priori. Its willingness to buy a depreciating asset (if the euro was not depreciating no need for the central bank to intervene) may run into practical limits or the political willingness to take such risks (imagine if EMU does unravel). The key 2-week CD rate now stands at 5 bp. They can cut it again, but they are running out of room. Or are they? Bill yields are negative. The 2-year yield is -18 bp. The first inflation-linked bond was sold this week and it had a negative yield. The 10-year yield is just below 100 bp, putting it about 20 bp below German yields. Yet the Danish 5-year CDS is well above Germany's at 133 bp vs 102 bp. Danish macro-fundamentals are constructive. Growth is forecast to be around 1% this year and 1.5% next year. The budget deficit is expected to fall from around 3.8% this year to less than 2% next year. Unlike Switzerland, though Denmark is not experiencing deflation. To the contrary Danish inflation is running just above 2% on a year-over-year basis. Ultimately of course, it is not Denmark's macro-economic factors that are the attraction. It is that is not the euro. Denmark is one of about 12 countries that enjoy the triple-A status, though its banks were recently downgraded. The Danish bond market is small and relatively illiquid. This discourages some investors who would otherwise want to invest there. Assuming that there is little more than can be done on official rates, there are three courses of action should the krone continue face pressure to appreciate. First, the central bank can have more aggressive intervention. Next week May's reserve figures will be published and investors will get some inkling to the extent of the recent intervention. Second, Danish officials can accept accept a wider band. The risk of this strategy is that it would simply goad the market and quickly the krone would likely move to the strong side of the wider band and officials would find themselves in a similar situation, but with a stronger krone. Third, Danish officials can implement what the Swiss have simply threatened: capital controls. While this is a drastic step, Danish authorities have not hesitated to act unilaterally if necessary to defend what it sees as its national interest. Not only did it refuse to join its neighbors' monetary union, most recently it unilaterally withdrew from the Schengen Treaty (open borders with other members).Denmark, like Switzerland, is resisting the forces that are meant to propel their currencies higher. The reference to currency wars seemed to be a reference to either the low US rates and unconventional Fed monetary policy or the reluctance of China to allow its currency to appreciate at faster than a glacial speed. Few understand the policies of the Swiss and Danish central banks in this context. Yet their stance is very much in the beggar-thy-neighbor mode. The European debt crisis is beginning to spur illiberal responses, or in game theory terms, defections from the liberal order.